Understanding investment risk

Last updated on 10 June 2016

Understanding investment risk

No saving or investment scheme is without risk. Whether it's risk to your original investment or the risk of inflation eroding the real value of your savings, all involve some degree of risk. As a general rule, the more risk you're prepared to take, the higher the potential rewards.

Your attitude to risk

Some people are cautious by nature while others are less risk-averse. But there are other factors which influence your attitude to risk.

Family circumstances. For example, if you have dependants you may be less willing to take risks than if you're single with no-one financially relying on you.

How long you're investing for. The longer your investment horizon, the more you are able to ride out any fluctuations in the value of your investments.

Your financial situation. If you only have modest savings and can't afford to lose these, you'll want to minimise your risk.

Capital risk

This is the risk of losing some or all of your money if your investment does not do well. All investments involve some capital risk unless they specifically state that the return of all your capital is guaranteed.

Inflation risk

This is the risk of inflation eating into the real value of your money. For example, if prices (inflation) rise by 5% a year but your savings by only 3% after tax, your money will not have kept up with inflation.

Liquidity risk

This is the risk of not being able to get at your money when you need it. For example, if you invest in a fixed-term savings scheme you won't be able to get at your cash until the end of this period or there may be a financial penalty for early withdrawals. Also, with some investments it's difficult to get at your money quickly. For example, if you buy property you won't be able to get at your cash until you've sold it which can take months.

Income or short-fall risk

This is the risk that returns from your savings or investments will be less than you expect. You may also be worried about the financial strength of the institution you save or invest with.

Reducing risk

There are various ways you can do this.

Don't put all your eggs in one basket but have a mix of different types of savings and investments. You can do this by choosing savings and investments from different asset classes. This way if one asset class does badly there is the chance that others might do better.

Within each asset class have a spread of different investments. For example, if you're investing in shares spread your money over several companies. A cheap and easy way to do this is to invest in a pooled investment fund such as a unit trust, OEIC or investment trust. And if you invest in several funds you spread your risk further.

Regularly review your savings and investments. Make sure your savings are still earning a good rate of interest and your investments are performing well. If your savings or investments are not doing very well, be prepared to switch. Also review the types of savings and investments you have. As you get nearer retirement or the date when you might want to access your money, you might want to reduce the amount of risk you take by switching from the higher-risk asset classes of shares and property to the lower-risk asset classes of cash and bonds.